Pros and Cons of Income, Market-based and Asset Based Valuation Approaches
An up-to-date business valuation provides the business owner with the essential information about the actual worth of the company in terms of market value, income or assets. While few companies dedicate enough resources to gain a complete knowledge about the worth of their business, having an accurate business valuation is essential. It helps the business owner to be in a position of strength when selling the business, handle the financial management more efficiently and know how much to reinvest into the business to ensure consistent growth.
What is the Income Approach?
The Income Approach values an entity based on its forecasted cash flows. The more common methods covered under this approach are the Discounted Cash Flow (DCF) Method and the Capitalisation Cash Flow Method.
Typically, in a Discounted Cash Flow model,
- Profitability and cash flow assumptions are made over a certain number of years. These include assumptions on revenue growth, cost drivers, future capital expenditures and working capital needs, taxes and depreciation estimates. These projections are typically provided by the firm’s management and the appraiser tests of reasonableness.
- A terminal value is then calculated, which is the amount that the firm or asset is estimated to be worth at the end of the projection period.
- Thereafter a discount rate is determined by considering a rate that reflects the risks of the business and the time value of money.
- The final value is arrived at summing up the present value of the projected cash flows and the terminal value.
The Discounted Cash Flow method is typically used to value publicly-listed, large and medium-sized firms. It is also used to value businesses that have rapidly fluctuating cash flow profiles (i.e. businesses that are not in steady state)
The Capitalized Cash Flow Method, on the other hand, is a simpler method. It estimates the cash flows for the following 12 months and discounts it by the capitalization rate.
This method assumes that the business or asset will experience stable growth, and hence, it can be used for small private firms that are expected to have smooth and steady profits on a yearly basis. It is also used when market comparables from public firms or precedent transactions are not available.
The key difference between the Capitalized Cash Flow method and the DCF is that the Capitalized Cash Flow method is applied to a single year’s cash flow, while the DCF considers multi-year discrete cash flows.
Pros and Cons of the Income Approach
One of the advantages that the Income Approach has over the other two approaches is that it is more flexible in addressing firms or assets that are in different stages of their life-cycle. This is because this approach factors in varying operating conditions over the projected period.
The Income Approach is also able to cater to the differing investment or ownership needs of the buyer and seller, by measuring risks through its discount or capitalisation rate, or by including cost synergies in its projections, for example.
Secondly, if there are no public market comparables or precedent transactions - especially for small private companies - this method can still be used to estimate the firm’s value.
The income based approach is more complex than the Market or Asset-Based approach and hence usually requires more time for its implementation.
This approach is dependent on the assumptions made on the forecasts which can be subjective, if the assumptions are not tested. The value derived from the Income Approach is also highly sensitive to the discount and capitalisation rate – a small change in the rate will cause a big change in the estimated value. This makes the exercise of determining an appropriate rate very important. This rate, however, has many variables which may also be subjective, such as projection risks, lack of liquidity risks and other company-specific risks. Hence, it is crucial for the valuator to understand the areas where judgement is required, considering the investment objectives and finding if the used rate is reasonable.
What is the Market-Based Approach?
The Market-Based Approach establishes the value of a business or asset by applying a price multiple on a specific business performance metric of the firm. The theory behind this approach is that the pricing multiples of comparable companies are similar.
There are generally two methods under the Market-Based Approach:
- Guideline Public Company method: Based on the price multiples of comparable companies
- Guideline Transactions method: Based on the multiples of precedent transactions of similar firms
The steps taken to value a firm with the Guideline Public Company method:
- First, a peer group of public companies is selected. The selection criteria can include, for example, industry, size and geographic location.
- Pricing multiples are determined. The price multiple is essentially a ratio of the value of the firm against a business performance metric. Some of the more common multiples include enterprise value to EBITDA (EV/EBITDA), price to earnings (P/E), price to book (P/B), and price to sales (P/S).
- The multiple is applied on the target company’s metric, and the value is adjusted for risks and growth prospects.
In the Guideline Transactions method, the multiples of prior acquisition transactions of similar companies are used.
Pros and Cons of the Market-Based Approach
Overall, the biggest advantage that the Market-Based Approach has is that it is easy to understand and less complex and time-consuming than the Income Approach. It is a quick and simple way to estimating your business’ worth once the right peer group is identified.
With the Guideline Public Company approach, there are many listed companies, resulting in a wealth of updated financial information. However, a large listed company’s multiple may not be reflective of a small private firm’s multiple. Public company multiples should be used in the context of a non-controlling ownership. The multiples should also be adjusted for size, lack of marketability and other growth or risk factors that a smaller, private firm has.
The Guideline Transactions method is the most appropriate one, if there is a controlling interest involved in the acquisition. The biggest challenge, however, is that there is a dearth of data for private company transactions. Private companies do not need to publish their purchase price or any other pertinent information. For public firms, if the transaction is small, they are also not required to announce their purchase price or the multiples used. If information is provided, the purchase price may also reflect synergies or risk factors that the buyer has imputed into the price tag that may not be relevant for the business-in-question. If it has been a while since the transaction occurred, it may also not be relevant as business conditions may have changed.
Another challenge that both methods have is that it may be difficult to find firms that are entirely the same as the business that is being valued. Hence, a multiple that indicates the valuation for a peer, may not be representative of the target company.
The Market-Based Approach is best used as a check against the Income Approach. If the target firm’s valuation multiple churned from the Income Approach is higher (lower) than the peer average, the firm is overvalued (undervalued). A detailed valuation will comprise more than one method to determine the firm’s value.
What is the Asset-Based Approach?
The Asset-Based Approach values the company from a balance sheet perspective. This approach generally estimates the value of the firm by taking a net difference between the value of its assets and its liabilities.
One of the more common methods under the Asset-based Approach is the Adjusted Net Asset Value Method. This method adjusts assets and liabilities to reflect the true values either on going concern, or under liquidation.
The Asset-based Approach typically gives the lowest valuation among the three valuation approaches.
How is the Adjusted Net Asset Value calculated?
The valuator typically begins by referring to the company’s balance sheet. The balance sheet reflects assets and liabilities at historical costs. Each balance sheet item is looked at in detail and restated to current market value. Some examples are:
- Adjustment to land, property, plant and equipment, inventories to reflect current market prices. These updated prices are typically done in hand with a third-party appraiser.
- Adjustment for intangible assets, such as trademarks, intellectual property
- Adjustment for any unrecorded liabilities
The difference between the sum of the fair value of the assets and the fair value of the liabilities provide the Adjusted Net Asset Value.
Pros and Cons of the Asset-Based Approach
The adjusted net asset value is often used by firms that may have a going concern issue and are undergoing liquidation. They may also be used for investment holding firms, such as real estate or financial investments, where its assets are determined using the market or Income Approach.
The main disadvantage of this method is that, unlike the Income Approach, it does not consider the future earning potential of the business. For going concerns, the real value of the business may be higher than selling its assets on a piecemeal basis, as internally created products are not recorded on the balance sheet. The exercise of measuring these intangible assets, however, can get complex and subjective and may be over- or understated.
The valuation of a business or company is more than a science, as it requires in-depth knowledge and experience, as well as utmost attention and accuracy from the valuator. Most business owners may find it difficult to do their own valuation since they do not have enough distance and objectivity to estimate the true company value. It is recommended to engage professional services to ensure maximum quality and precision. With our expertise at AM Corporate Services, we will provide comprehensive analysis and a competent valuation of your business.